Work in process (WIP) Inventory .

What is WIP?

Most non-accountants (and some accountants) think of work-in-process
as a description of the physical state of inventory in a manufacturing
operation. For example, you have something on the shop floor that you've
done something to, but you still have more things to do to it before it
is a finished item. If it weren’t for computerized MRP / ERP inventory systems and
accountants, that simple description would probably hold true.

The reality is work-in-process (WIP) has two different meanings. One
that describes the physical state of the inventory, and another that
describes an account used to track the value of work-in-process.
And this is where the confusion starts.

You would think that the inventory we describe as WIP based on its
physical state would be the same inventory represented by the WIP
account. But that would be too easy. The WIP account represents the
value of materials, labor, machine time, and overhead reported as
consumed to produce something that has not yet been reported as
completed (It’s actually a little more complicated than this, but I’ll
get to that later). Okay, you say, but that still sounds like the value
of the inventory we call work-in process based on the physical state.

The big difference here relates to “reported as consumed” and
“reported as completed”. Whether something is reported as consumed or
reported as completed has to do with the bill-of-materials (BOM)
structure, the transactional methods being used, and the procedures
related to when and how things are reported.

How BOM structure affects WIP.

Let’s say we’ve got a little operation that makes ceramic coffee mugs
with clever little sayings on them. Let me first say I don’t really know
much about making pottery so please don’t email me if my descriptions
are not technically correct. Now back to the example.

We start by mixing the clay from our special recipe of raw materials,
and then we form the clay into mugs, let them dry, and fire them in the
kiln. We then apply our clever little sayings on them with glaze and
throw them back in the kiln. Now we have our finished mugs.

If our bill-of-materials and routing is set up such that the raw
materials that go into the clay, the glaze, and all the operations
required to product the finished mug are on one BOM (and therefore
everything is produced using a single production order), everything we
touch in the process is considered to be WIP up until the finished
product is completed. Therefore, the mixed clay, the formed mugs drying
and awaiting the first kiln firing, the fired mugs awaiting glaze, and
the glazed mugs awaiting the final firing, are all part of WIP—or, more
specifically, the value associated with these items is part of WIP.

However, if we have one BOM to create the clay, another BOM to turn
the clay into unglazed mugs, and another to turn the unglazed mugs into
finished glazed mugs, things are a bit different. In this scenario, the
mixed clay and the unglazed mugs are no longer part of WIP. That’s
because once you’ve finish mixing the clay, you report the clay as
completed on its own production order. It now exists as an inventoried item (Clay). And once you’ve
formed the clay into mugs and fired them in the kiln, they are no longer
part of WIP because you will report the unglazed mugs as completed on
their own production order, and
they will now exist as an inventoried item.

Under this scenario, the clay being mixed, the formed mugs waiting to
be fired in the kiln, and the mugs that have been glazed and are waiting
to be fired in the kiln are part of WIP. That is because they have been
changed from their inventoried state (either clay or unglazed mugs in
this case) but are not yet completed to another inventoried state.

To clarify “inventoried item” and “inventoried state”, this
represents items that can be tracked in your perpetual inventory system.
This means they have a unique item number (SKU number) that is
associated with that item in that state. And that your “inventory
system” (your computer) tracks quantities associated with these items.
Therefore, you should be able to inquire into your inventory system to
see how many of that specific item you have in stock.

So, based on the 2nd WIP example previously covered, we would have a
unique item number for the “unglazed mug” that is tracked in our
inventory system. When we complete production of the unglazed mugs, we
enter a transaction that puts the unglazed mugs into stock. Whereas in
the 1st WIP example, the unglazed mugs do not have a unique item number
and are not put into stock. They instead remain part of WIP.

To put it another way, you can think of the WIP account as
means of tracking the value of inventory that is in a state that is not
set up to be tracked in the perpetual inventory system. It is
essentially a necessary compromise (some may say necessarily evil) used
to maintain the integrity of the accounting system without creating
insanely complex levels of inventory tracking.

What if I want to track the value of the unfinished
"inventoried items" AND the stuff in the WIP together?

This is actually very common. Businesses like to
classify their inventory to better understand where their inventory
investment is, and the executives really don't want to hear about the
nuances of how the bill-of-material structure affects what is being
reported as "work in process". Most business accounting systems
will allow you to set up multiple inventory accounts. All you need to do
is set up an inventory account called "unfinished goods" or "in process
inventory", then attach all unfinished inventoried items to this
account, and make your WIP account a subaccount of this account.

How transactional methods and procedures affect WIP.

The bill-of-materials structure helps us to understand in theory what
is and is not part of work-in-process, but in order to fully understand
the WIP account in practice, you also need to understand your
transactional methods and procedures. Remember earlier when I mentioned
the importance of “reported as consumed” and “reported as completed”
with WIP. In theory, things are reported as consumed when they are
consumed, and reported as completed when they are completed. In practice
however, the timing of these transactions can vary significantly from
the physical activities associated with them.

For example, if I choose to have material handlers pick raw materials
from storage based on the needs of specific production orders, deliver
them to the work station, and issue the materials to the production
orders at the same time. These raw materials are now part of WIP even
though nothing has been done to them other than physically moving them
to the workstation. They may sit around for days or weeks in the staging
area and physically be no different from the raw materials in the
storage areas, but they are part of WIP because we already did the
transaction. If however, I choose to not have the material handlers
issue the materials (they would still deliver them), and instead use
backflushing transactions to issue the materials when the machine
operator reports production, then these materials will not be part of
WIP when they are staged, or even after they have been physically
consumed assuming the backflush transaction has not yet been done.
Read my article on Backflushing to get a better understanding of these
types of transactions.

And then there’s stuff like labor and overhead.

Remember, WIP is an account used to track the costs associated with
production of goods. Materials consumed in production is only one
part of these costs. We are also often tracking costs related to
labor, machine run time, and overhead. Exactly what you track depends on
how you set up your manufacturing system, but these costs can have a
significant impact on the WIP account and can help to demonstrate why
thinking of WIP as physical inventory is problematic.

For example, if I’m producing an item on a machine that requires
extensive setup for each production run, I will have labor and possibly
machine and overhead costs associated with this setup. When I complete
the machine setup, I will report labor and other costs (enter them into
the computer system). At this point in time, these costs go into the WIP
account even though there is nothing physically existing to associate
with these costs.

Let’s see how we can use costs to make WIP even messier.

Earlier I said “The WIP account represents the value of materials,
labor, machine time, and overhead reported as consumed to produce
something that has not yet been reported as completed.” Since then,
you’ve seen how this is more complicated than it sounds, and now it’s
going to get really ugly. That’s because how we “value” inventory can
sometimes create problems. If we ran on “actual cost” the WIP account
would be stay rather clean (in theory). That’s because when we report
the production of the finished item, the system will take all those
costs that went into WIP and use those to calculate the value of the
finished items being reported. Therefore, the value taken out of the WIP
account when you complete a production order will equal the value that
went into WIP to produce that order.

The problem is, many businesses do not use actual cost for their
finished goods (and for good reason, but that would be another article).
They instead use something called “standard cost”, which is the
calculated cost of the finished item based on the “expected” costs.
However, they often use actual costs to report into the production
process (actual labor and machine time, and sometimes the actual labor
rates of the specific individuals performing these tasks). Since the
actual costs to produce something never exactly match the expected
costs, you will always have variances in the WIP account because the
value of goods produced coming out of the WIP account does not exactly
match the value of materials, labor, machine time, and overhead going
into the account.

On the surface it may sound stupid to use standard cost to value the
finished product yet apply actual costs to the production, but there are
valid reasons for this. It basically comes down to wanting to track
actual costs associated with production without having the variability
of the actual costs associated with individual production runs (and
production-reporting errors) affect the cost of the finished items.